- As rates rose and liquidity declined in 2018, it became very clear how sensitive some parts of the real economy were to higher rates.
- We focus on opportunities where market perceptions of stocks are too extremely negative, and the resulting overreaction creates an exploitable difference between price and value.
- Our portfolio turnover typically follows volatility as it creates opportunities, and this was once again the case as we added several new names in the fourth quarter.
Market Overview and Outlook
When Ben Graham famously anthropomorphized the financial market with his Mr. Market metaphor, he compared the market to a business partner that offered to buy or sell an ownership position in the stock market at a different price every day. This framing was powerful as it captured the underlying behavioral arc of markets as they oscillate between the depressed prices of fear and the exuberant prices of greed. It also captured that most of the time prices are roughly right, and you have the very valuable option of sitting on your hands. Obviously, this framework resonates very powerfully with investors as it has stood the test of time.
We refer to Mr. Market often, but rather than as an emotional business partner, we think of Mr. Market as an opposing, but dominant poker player. Through the market’s constant price action, Mr. Market’s poker game provides a continuously updating stream of probabilities on possible futures, which are broadly correct. Thus, we often choose not to play or fold early in hands. Occasionally, however, we disagree enough with Mr. Market’s probabilities to make long-term active bets against the market’s passive expectations. This modification from partner to player allows us to think about the market as more of a continuum of expectations that we can reverse engineer, and thus price, through our active valuation process. The added benefit of thinking of the market as a probability-driven game is that it more fully captures the dynamic and complex nature of markets and the role of game theory, even if the underlying emotional drivers of fear and greed power both frameworks. In other words, markets are constantly evolving, and one of the great intellectual challenges for investors is to evolve with the game as it is being played across market cycles. As active managers, we have been challenged by Mr. Market’s recent changes, but these greater challenges are also creating greater opportunities.
The biggest change to Mr. Market during this market cycle is the increasing dominance of passive flows. In previous market cycles, indexes were a tool to passively measure the market. The market poker game always had dominant players, but they were a combination of mostly active players that ensured a diversity of underlying causal drivers in setting price and embedded expectations. With the increased dominance of passive, causality has been reversed as indexes set, rather than just reflect, the price. The market has always had a self-referential feedback loop where price drives price, but the intensity of the passive feedback loop is accelerating and crowding out other players. The only active solution has been to get in line with the market’s hot hand by following the price momentum that is fed by passive flows.
The transition to digital has been a reinforcing change that has made the market even more self-referential. The digitization of markets has removed frictions and allowed the market to concentrate capital to an unprecedented degree. Just as digital creates winner-take-all dynamics in the real economy, this concentration of capital has created a winner-take-all dynamic for large-cap U.S. indexes over this market cycle. At the same time, digital has allowed the number of indexes to grow at an almost exponential rate, and the number of indexes now vastly exceeds the number of underlying securities, further cementing the index at the causal center of market action. The result is a market that is more inwardly focused than ever. Like a screen-addicted teen, we have a selfie-taking market that is using a digital mirror to focus intensely on itself.
These changes have intensified the game theory dynamics that are always at play in financial markets. As Keynes’ beauty contest framing so effectively captured, successful investing requires you to anticipate what the collective investor perception of the most attractive stocks will be. Figuring out what is true is often less important than figuring out what investors believe and are focusing on, and how they will react to changes in their perceptions over time. This game theory element of markets always introduced a layer of abstraction beyond what we considered the long-term truth of fundamentals and valuation, but we always try to tackle the higher-order thinking required of game theory as we frame expectations bets against Mr. Market. Specifically, we focus on opportunities where market perceptions of stocks are too extremely negative, and the resulting overreaction creates an exploitable difference between price and value.
Over the last two years it has been difficult to fully appreciate the intensification of game theory that came with a selfie market focused predominately on price. Essentially, rising stocks were increasingly beautiful, while declining stocks were increasingly ugly. Price has shaped investor perceptions and capital flows to such a degree that the most beautiful object of all has become the index itself. Timing is always a challenge for valuation-driven investors, but by not fully appreciating this intensification around price momentum we were moving too fast in selling winners and adding to declining stocks. We will always be disciplined within our investment process, but we have adjusted our timing of exit and entry to more fully anticipate the digitally enhanced intensification of Mr. Market’s adored and hated stocks.
A Rosy Narrative Disrupted
Fortunately, the market’s poker game is dynamic and constantly evolving, and it seems to be shifting in our favor. From a cyclical perspective, we tend to do better when volatility is higher, and the market is essentially arguing with itself as it is forced to entertain a wide range of possible futures. A year ago, no one was arguing with Mr. Market and he was running the table with a static set of probabilities. Volatility was in the basement, everyone was fired up about tax cuts and global synchronized growth, a prominent value investor was calling for a price momentum melt up, and Mr. Market had extreme confidence in extrapolating the benign conditions into 2018.
The perspective changer was that extrapolation was surfing on a wave of liquidity, which was starting to slowly recede. As rates rose and liquidity declined, it became very clear how sensitive some parts of the real economy were to higher rates. It’s hard to untangle causality, even in hindsight, but marginal growth in emerging markets, and housing and manufacturing all slowed as 2018 progressed. This shifted the previously rosy narrative to concerns about the escalating trade war, government dysfunction globally, and overly optimistic growth expectations for 2019. Rather than taking away the punch bowl, the Fed took away the selfie market’s credit card.
To be clear, the market at the index level still has a huge advantage over most investors, because it frames the world more simply and reacts faster. In this age of abundant information, everyone claims to be “data driven,” but the reality is that people are and will always be narrative driven. Our digital world can provide data to support pretty much any perspective, true or false, and people use it to reinforce and cling to their narratives. It results in pleasure from confirming data, and disgust and anger from disconfirming data. This just reinforces people’s ancient behavioral biases, while the market’s reaction function is cleaner and essentially digital in nature: it rises with greed and falls with fear. As a little bit of fear surfaced during early and late 2018, the market moved violently, with passive flows reacting with a reinforcing lag to their only guiding light of realized price moves. As the dominant player, Mr. Market remains a formidable forecaster, as self-referential feedback loops can create the forecast through the resulting wealth effect. The irony, however, is that we think the intense inward focus on the market may have diminished some of the market’s forecasting skills as the inputs in deriving price have become too internally focused. If so, the danger in betting against Mr. Market, which has been so vexing over this market cycle, may have started to shift in favor of contrarian active strategies.
The Market Is Still Moved by Emotion
It may seem like heresy to say it these days, but, as a human creation that ultimately reflects shifts in fear and greed, the market sometimes over- and underreacts to changes in underlying fundamentals and valuation. At a macro level, we will give an example for each type of reaction where we think the market may be getting it wrong.
Starting with overreaction, investors are intensely focused on what they rightly perceive as a critical driver of markets: the probability of a U.S. recession in 2019. As fear crept into the market in 2018 it did not do it quietly. Valuation multiples compressed by over 20% as growth expectations for 2019 were almost cut in half. By many metrics the financial markets seem to be pricing in a 50% or higher probability of recession over the next 12 months, with many cyclical stocks already priced for a mild or deeper recession. Most recession models have also raised the probability of recession in 2019, but they remain at approximately 20% or less.
Currently, we would bet with the models. Why? The U.S. consumer, or what we might call Main Street as opposed to Wall Street, is roughly 70% of the U.S. economy, and is broadly in great health. Unemployment is at historically low levels, wages are accelerating, and the consumer has used these tailwinds to fix their own balance sheets (Exhibit 1). The models are likely doing a better job of reflecting the importance and health of Main Street, while Mr. Market continues to climb a steep wall of worry as the scars of the Great Financial Crisis (GFC) run deep. After all, the GFC was a solvency crisis that almost collapsed the economy into depression, and the market remains deeply suspicious of all things cyclical.
Exhibit 1: Consumer Balance Sheets Have Improved
Just measuring the risk of a U.S. recession may miss critical macro risks. After all, we had a deep energy recession in 2016 that did not tip us into a broad recession, but certainly elevated market risk. As liquidity has become scarcer, more risks are emerging globally that could be far larger in magnitude than the 2016 experience. However, we think any major issues will turn the monetary spigots back on, and risk premiums should recede from currently elevated levels. However, as Wall Street begs for an infusion of liquidity, we think Mr. Market is underreacting to an ongoing change in broader policy.
This market cycle has been dominated by monetary policy, which had an explicit goal of supporting asset prices to drive a wealth effect. Essentially, the liquidity pump was blown wide open to directly benefit Wall Street, in order to indirectly help Main Street. The unexpected problem with this policy is that it inflated asset prices, which greatly exacerbated wealth disparity. The resulting voter anger has driven the rise of populism and has shifted the focus to directly benefiting Main Street through fiscal policy. With the U.S. on track to experience record deficits outside of a recession or a major war (Exhibit 2), populism, by encouraging tax cuts, which are ultimately inflationary, is forcing a tightening of monetary policy. This modest liquidity shift has already caused market tremors and slower growth, and we expect both policies to now work in concert. If they do, we think a normalizing term premium will push interest rates higher and further fuel the three-year old bond bear market. Despite the recent drop in yields, we believe the probability of a continued bond bear market has gone up. Wall Street will attempt to restore the old price momentum game despite recent large cracks and signs that new winners are starting to emerge. We have tried to position the portfolio to benefit as Mr. Market adjusts to the new realities of a shift in focus to Main Street, and despite recent extreme market turmoil the portfolio held up better later in the fourth quarter. It’s an early but encouraging sign.
Exhibit 2: Deficits Near Cycle Highs
Volatility Has Created Some Valuation Opportunities
In positioning the portfolio, we truly welcomed the shattering of the calm that characterized early 2018. Although the overall stock market is still not presenting a broad valuation opportunity, there are many stocks where embedded investor expectations have collapsed to a level that makes little sense outside of a recession, and in some cases a severe recession. Although this reset in expectations spared few groups, as it even hit the mighty FAANGS, the continued collapse in cyclical sectors to record-low S&P 500 Index weighting and valuation was our focus (Exhibit 3). These orphaned groups contain many companies that are generating record amounts of cash flow, have healthy balance sheets, and are allocating capital intelligently. If we are broadly correct that recession fears are overdone, we think we are well-positioned as extremely depressed expectations rebound. This is especially true if dual fiscal and monetary policy ends up driving rates higher, as we believe it will. Conversely, if we do enter a recession soon there will certainly be more price risk to endure, but we are starting to see stabilization in many stocks that already reflect this bad outcome. Our portfolio turnover typically follows volatility as it creates opportunities, and this was once again the case as we added seven new names in the fourth quarter. We briefly detail the new holdings below.
Exhibit 3: Falling Weight and Valuations for Cyclicals
The worst-performing group in 2018 and arguably the most hated cyclical group is energy. The stocks have formed a nasty habit of not going up with the price of oil, but still managed to follow it down when oil prices collapsed in the fourth quarter. In energy we added two names:
- We used the selloff to add to high-quality services name Halliburton after it declined 50% in 2018. The decline followed negative revisions as North American shale service activity, which is extremely sensitive to the oil price, slowed as we entered 2019. The stock is trading at roughly 8x (arguably “trough”) EBITDA, has a decent balance sheet and is still generating ample free cash flow. We expect services activity to rebound as the price of oil stabilizes and likely recovers later in 2019, and expectations embedded in Halliburton stock are way too low against this outcome.
- The sensitivity of shale activity has gone up as some select shale production companies have found something they never exhibited before: capital discipline. One of the companies exhibiting this discipline and returning capital to shareholders is Encana, a Canadian natural gas and shale oil producer. Encana had already dropped 25% with the decline in oil prices in October when it announced an acquisition of Newfield Exploration, a shale producer focused on the much-maligned Scoop/Stack shale play in Oklahoma. The market hated this deal, and Encana’s stock dropped another 50% to finish out the year. The resulting valuation was a sector-low 4.5x EBITDA, despite Encana’s plan to generate free cash flow and buy back roughly one quarter of its stock. This double collapse in expectations warranted a small position in the portfolio.
Outside of energy, two cyclical sectors that have been hit hard by higher interest rates are housing and autos, where consumer demand slowed materially in 2018. Both groups were the center of the storm during the GFC, and the market’s reaction has been to shoot first and ask questions later. We added one housing and one auto name during the quarter:
- On the housing side we added one of the best-managed and best-positioned builders in Lennar, after the stock dropped nearly 50% from its early 2016 peak. The recent slowdown is a clear negative, but we still think the housing market is well-positioned to continue grinding higher. Housing starts are still well below historic averages, there is likely a deficit of housing stock as investment collapsed following the housing crisis, and accelerating household formation and job growth are spurring long-term demand. Despite these positives, the stocks reacted violently to the slowdown, and we were able to buy Lennar stock at 6.5x earnings and at a depressed multiple of book value.
- On the auto side we initiated a position in Volkswagen. Following the horrific diesel scandal, Volkswagen shareholders have finally gotten what they needed: a new management team focused on creating shareholder value and investing in the major platform transition to electric vehicles. To surface shareholder value, we expect Volkswagen to spin off its major truck business, Traton, and potentially follow this with a separation of its incredibly valuable position in Porsche. These corporate actions could result in Volkswagen selling somewhere between 1x and 2x earnings, despite Volkswagen spending over $30 billion in capital to create arguably the most extensive offering of electric vehicles by early next decade. Despite ample free cash flow and a decent balance sheet, Volkswagen stock already sells at a meaningful discount to the depressed auto group, embedding considerable cyclical downside at current levels.
Outside of traditionally cyclical areas, we took advantage of downside volatility to add a consumer staple, and two information technology (IT) stocks:
- Within consumer staples we bought “quality when no one wants it” with an investment in Anheuser-Busch InBev after the stock fell over 40%. Anheuser-Busch has a dominant share in the global beer market but should exceed industry growth due to its greater than 50% footprint in emerging markets, and it enjoys a very high level of profitability with an operating margin above 30%. Despite these long-term positives, earnings and cash flow got hit by the strength in the U.S. dollar. These headwinds slowed Anheuser’s deleveraging plans, with debt above long-term targets at 5x EBITDA. This resulted in a 50% dividend cut, which catalyzed our investment in the stock, as it will allow the company to reduce debt quickly. It is rare to get high-quality global staples franchises at reasonable valuation multiples, but our purchase at 14.5x earnings and a 7% free cash yield qualifies.
- Within IT we invested in the leading all-flash storage company NetApp. Despite very strong double-digit earnings growth, NetApp’s valuation multiple was stuck below the market and the IT sector due to two concerns. First, that NetApp faced potential share loss in on-premise storage from a more aggressive legacy competitor, EMC/Dell. Second, that NetApp would lose share as storage transitioned to the cloud. We think these concerns are overdone, and conversely, we think NetApp’s next wave of growth will come as it ramps its own cloud-based file storage software offering. Continued success in on-premise storage more than justifies a higher value based on our analysis, while any traction in cloud is a free growth option.
- Perhaps our most controversial new position is in the fallen FAANG stock Facebook, where we initiated a small position after the stock fell almost 40% from its mid-2018 highs. Investors turned bearish on Facebook after several well-publicized security and privacy breaches highlighted the power of an unregulated platform with 2.3 billion users. These challenges have raised the risk of regulatory action and have spurred the company to invest heavily to address these digital-era issues. The ongoing investments will slow revenue growth materially in 2019 to roughly 20% from 35% previously, while operating margins will decline from 50% to the low 30% range. The result is no earnings growth in 2019. However, we think this pause in growth is a good thing for the long term, and that the value of the network is higher than current embedded expectations, especially given the continued growth in Instagram.
We live in a dynamic world that is constantly changing. A healthy market tries to reflect these changes through a normal level of volatility as Mr. Market constantly entertains a wide range of possible futures. For most of this cycle Mr. Market has been increasingly insulated from the real world by a flood of liquidity. As a result, Mr. Market’s internal gaze had created excessive levels of self-referential comfort as we began 2018, and as active valuation managers the market’s comfort was our discomfort. We think we are now observing markets being forced to take less selfies, as higher volatility and lower investor expectations challenge the status quo. Change always brings challenges, but these changes come with broader opportunities for active valuation managers like us.
The ClearBridge Value Equity Strategy had a negative return during the fourth quarter, underperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in two of the 11 sectors in which it was invested during the quarter (out of 11 sectors total). The primary contributors to the Strategy‘s performance were the materials and utilities sectors.
In relative terms, the Strategy underperformed its benchmark primarily due to stock selection decisions during the quarter. Stock selection in the health care and financials sectors detracted the most from relative returns during the period. An overweight to the energy sector and an underweight to consumer staples also weighed on returns. Conversely, stock selection in consumer discretionary, materials and IT sectors, contributed positively to relative results. An overweight to utilities likewise boosted relative returns.
On an individual stock basis, the greatest contributors to absolute returns during the quarter were positions in Royal Gold, AutoZone, Merck, Exelon and AES. Allergan, Alexion Pharmaceuticals, Devon Energy, American International Group and Alphabet were the largest detractors from absolute performance.
During the quarter, in addition to adding the companies discussed above, we closed positions in Apache, Realogy, Johnson Controls, Lowe’s, TransDigm, AECOM, Molson Coors and Adient.